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Board of Governors of the Federal Reserve System

International Finance Discussion Papers
Number 1104

May 2014

Sovereign Debt Crises

Ricardo Correa
Horacio Sapriza











NOTE: International Finance Discussion Papers are preliminary materials circulated to
stimulate discussion and critical comment. References to International Finance Discussion
Papers (other than an acknowledgment that the writer has had access to unpublished
material) should be cleared with the author or authors. Recent IFDPs are available on the
Web at www.federalreserve.gov/pubs/ifdp/. This paper can be downloaded without charge
from the Social Science Research Network electronic library at www.ssrn.com.
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Sovereign Debt Crises

Ricardo Correa
Horacio Sapriza
*



Abstract
Sovereign debt crises have been recurrent events over the past two centuries. In recent years, the
timing of sovereign crises has coincided or has directly followed banking crises. The link
between sovereigns and banks tightened as the contingent liability that the banking sector
represents for the sovereign grew, as financial safety nets became more common. This chapter
analyzes the transmission channels between sovereigns and banks, with a focus on the effect of
sovereign distress on bank solvency and financing. It then highlights the notable cost to the real
economy of the close connection between sovereigns and banks. Breaking the feedback loop
between these two sectors should be an important policy priority.

Keywords: Sovereign default, banking crises, government guarantees, financial safety net, bank
regulation.
J EL Classification: E44, F34, G01, G28

*
Ricardo Correa, Horacio Sapriza: Division of International Finance at the Board of Governors of the Federal
Reserve System (emails: ricardo.correa@frb.gov, horacio.sapriza@frb.gov). We thank Allen N. Berger, J ohn O.S.
Wilson and Phil Molyneux for very helpful comments. This paper was prepared for the Oxford Handbook of
Banking. The views expressed in this paper are solely the responsibility of the authors and should not be interpreted
as reflecting the views of the Board of Governors of the Federal Reserve System or of any other person associated
with the Federal Reserve System.

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1. Introduction
Sovereign debt crises have been recurrent events over the past two centuries (Reinhart
and Rogoff, 2009). In the earlier days, these crises were mostly associated with large and costly
endeavors like wars and with fluctuations in commodity prices. More recently, sovereign debt
crises have been increasingly linked to the banking sector. As noted in Reinhart and Rogoff
(2011), banking crises typically precede or coincide with sovereign debt crises. Although the
frequency of twin sovereign debt and banking crises is not as high as that of episodes that
include a currency crisis (Laeven and Valencia, 2012), the recent European sovereign turmoil
has shown that the economic impact of this type of twin crisis can be deep and prolonged.
Figure 1 provides a schematic characterization of the link between sovereigns and banks.
Problems in the banking sector, which could lead to a full fledge crisis, can have a notable effect
on the sovereigns condition (the left arrow in the figure). There are two main channels through
which this transmission can take place. First, a more encompassing banking safety net
increases the contingent liability associated with banking failures for the sovereign. In a banking
crisis, the government may assume a sizeable portion of banks liabilities, affecting its own
solvency. Second, the transmission of banking shocks to the sovereign can also take place
indirectly. The role of banks as the primary financial intermediaries in a country implies that
problems at these institutions may affect aggregate macroeconomic conditions, and subsequently
lead to deterioration in the fiscal position of the sovereign.
[Insert Figure 1]
The connection between sovereigns and banks can also flow in the opposite direction (the
right arrow in Figure 1). Doubts about the fiscal soundness of the sovereign, unrelated to the
banking system, can also affect banks performance. In the extreme case of a sovereign default,
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losses incurred by the banks due to their holdings of government issued securities could threaten
their solvency. Similarly, as sovereign stress leads to an increase in debt yields, funding costs
for banks will likely rise and impact bank profitability. In some cases, the effect of sovereign
stress on funding costs may be larger for those banks that are deemed to be too-big-to-fail by
the market. As the ability of the government to support these banks is questioned by investors,
funding costs can increase relative to those of other banks.
Although these linkages between sovereigns and banks may act separately and with a
causal direction, it is also possible that they devolve rapidly into a feedback loop. Problems in
one of the two sectors can be amplified by the interconnections and negative effects noted above.
In these circumstances, the outcome of this type of twin crisis can have deep implications for
aggregate economic activity (the bottom arrow in Figure 1).
The deep linkages between banks and sovereigns are, in some cases, exacerbated by
banking regulation and the prevalence of a bank safety net. To weaken the feedback loop
between sovereigns and banks, there has to be a reassessment of these policies. The focus should
be on reducing the contingent liability to the sovereign that represents its connection to the
banking sector. Policy actions like establishing a clear and transparent resolution framework for
banks of all sizes should contribute to break this loop. Similarly, policies that enhance market
discipline and the accurate assessment of sovereign risk should lead to more resilient bank
balance sheet that could absorb a wider array of shocks arising from sovereign distress.
Section 2 provides a historical overview of sovereign debt crises. It also describes the
causal connection from banking crises to sovereign stress. Conversely, sovereign crises can
impact banks solvency and funding conditions, and the channels that explain this connection are
reviewed in Section 3. The feedback loop between sovereigns and banks can amplify shocks
5

affecting one of the two sectors, and then impact the real economy, a topic that is covered in
Section 4. Lastly, Section 5 discusses some adjustments to the financial safety net that could
break the link between sovereigns and banks.

2. Transmission from banking sector stress to the sovereign

2.1 An overview of sovereign debt crises
Sovereign debt crises are a recurring feature in the international financial landscape. For
example, Reinhart, Rogoff, and Savastano (2003) report that France defaulted on its sovereign
debt eight times between 1500 and 1800, while Spain defaulted thirteen times between 1500 and
1900. Tomz and Wright (2007) document 250 sovereign defaults by 106 countries between
1820 and 2004.
From a legal perspective, a default episode is an event in which a scheduled debt service
is not paid beyond a grace period specified in the debt contract. Sovereign defaults do not
necessarily imply a total repudiation of the outstanding debt, and any sovereign restructuring
offer containing less favorable terms than the original debt contract is considered a technical
default by credit-rating agencies. Most sovereign default episodes are followed by a settlement
between creditors and the debtor government. The settlement may take the form of a debt
exchange or debt restructuring, and the new stream of payments promised by the government
generally involves some combination of lower principal, lower interest payments, and longer
maturities (Cruces and Trebesh, 2013). Credit-rating agencies define the duration of a default
episode as the time between the default event and when the debt is restructured, even if there are
holdout creditors.
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Default episodes have occurred in clusters, often following lending booms and large
capital inflows. Subsequent periods of quiet typically reflect both more cautious behavior of
borrowers and the loss of capital market access for riskier borrowers. The wave of defaults
associated with the Great Depression and the Second World War marks the last period of default
in Western Europe during the twentieth century. Developing countries defaulted in even greater
numbers during that period, and they did not access capital markets for several years afterward.
Lending to developing countries resurged in the seventies in the form of syndicated bank loans,
in contrast to previous periods, when bond issuance had been the main borrowing vehicle. A
spate of sovereign defaults followed in developing economies, beginning in the 1980s. The
amount of sovereign debt in default peaked at more than $335 billion in 1990. This debt was
issued by 55 countries (Beers and Chambers 2006). Soon after the Russian sovereign debt crisis
in 1998, several emerging markets experienced sovereign debt episodes. These emerging market
episodes and the European sovereign debt crisis of 2009-2012 invigorated the study of sovereign
defaults and motivated several policy initiatives intended to improve the international financial
architecture, including the effectiveness of crisis resolution.
Many circumstances can lead to a sovereign debt crisis. Political factors can be
important determinants of sovereign debt events, as evidenced by the recent European crisis.
There is a large literature discussing the links between political risk and sovereign defaults
(Bilson, Brailsford, and Hooper, 2002; Cuadra and Sapriza, 2008; Hatchondo, Martinez, and
Sapriza, 2009). Empirical studies have also highlighted the importance of external factors in
raising the borrowing cost of countries, and thus increasing the likelihood of a sovereign default.
For instance, Arora and Cerisola (2001) and Uribe and Yue (2006) find that the interest rates
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paid by sovereigns in emerging markets have tended to move in the same direction as U.S.
interest rates.
Empirical evidence also indicates that a sovereign tends to default in periods of low
available resources. Government resources are low during a cyclical downturn. Tomz and
Wright (2007) report that 62 percent of defaults over the last 200 years occurred in years when
the output level in the defaulting country was below its long run trend. Fluctuations of terms of
trade (ratio of the price of exports to the price of imports) are an important driving force behind
the business cycles in some emerging economies (Mendoza 1995, Broda 2004). At the same
time, several emerging economies strongly rely on commodity taxation as a source of public
revenues and depend largely on imported intermediate goods that have no close substitutes.
Some authors find that terms of trade fluctuations are a significant predictor of sovereign default
and interest rate spreads in emerging economies (Caballero, 2003; Cuadra and Sapriza, 2006).
Events adversely affecting a countrys productivity, such as wars or civil conflicts, can also lead
to sovereign defaults (Sturzenegger and Zettelmeyer, 2006).
Defaults may also be triggered by a devaluation of the local currency when a relatively
large fraction of the sovereigns debt is denominated in foreign currency and its revenues rely
heavily on the taxation of nontradable goods. The magnitude of crises triggered by a devaluation
of the local currency can be amplified by currency mismatches of households, the non-financial
corporate sector, or the banking sector. The next section discusses in more depth how stress in
the banking sector may lead to a sovereign debt crisis.



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2.2 Sovereign debt crisis as a result of banking crises
Banking crises are very frequently followed by or concurrent to sovereign debt crises, as
documented by Reinhart and Rogoff (2011). Banks lie at the heart of the payments system, so a
downturn in this sector can readily spread through the rest of the economy, with far reaching
consequences for both the private and public sectors. As a result, governments have very strong
incentives to avoid disruptions in the banking system. The recent European crisis offers the
latest evidence as to the large extent to which governments may go to rescue their banks, making
it clear that financial sector problems tend to become fiscal sector problems. In that way,
banking crises commonly set the stage for sovereign debt crises. Banking crisis episodes like
those in Ireland in 2008 and in Spain in 2012 showcase how the liquidity and solvency troubles
of the banking sector can radically turn into a fiscal burden sufficiently large to lead into a
sovereign debt crisis that requires external assistance for its containment.
Banking crises may translate into sovereign debt crises through two types of risk
transmission channels. A first set of channels is associated to the role of the government as the
provider of a safety net to the financial system, and the resulting presence of government
contingent liabilities. A second set of channels relates to the existing domestic structural
macroeconomic conditions at the time of the crisis.
The government plays the role of a safety net to the banking system via three
mechanisms: first, a governments commitment to provide support to the banking sector through
explicit or implicit bank liability guarantees can saddle the government with substantial debt
from private banks, and thus leave it financially vulnerable. For instance, the 27 member
countries of the European Union (EU) approved government guarantees on bank liabilities
totaling about 30 percent of 2011 EU GDP from the first quarter of 2008 to the third quarter of
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2012. There is an important dispersion in the value of guarantees across these countries, with
Ireland providing the most guarantees at about 250 percent of 2011 GDP. As Acharya,
Drechsler, and Schnabl (2013) highlight, Irelands provision of blanket guarantees on deposits of
six of its largest banks on September 30 of 2008 was immediately followed by a sharp decline in
the credit default swap (CDS) premiums for banks and an equally marked increase in the
governments CDS premium, which over the next month more than quadrupled from about 100
basis points to 400 basis points within six months. The sharp increase and opposite move in the
sovereign CDS premium in Ireland strongly suggests that the provision of guarantees by the
government to the banking sector resulted in an important risk transfer from the banking sector
to the government. The sovereign interest rate spread of Irish bonds over comparable German
debt instruments rose to historically high levels, and Ireland eventually needed a bailout in 2010.
Acharya, Drechsler, and Schnabl also point out that this episode is not isolated to Ireland.
Second, sovereign bailouts are a major source of concern about fiscal sustainability. The
extent to which the liabilities of the banking sector are socialized and the costs are transferred to
taxpayers depends significantly on the resolution regime adopted for the stressed banks (Laeven
and Valencia, 2010). Moreover, the lack of schemes to resolve insolvent institutions can result
in the banking sector generating a large contingent liability for the sovereign. Hence,
governments often contemplate a wide range of measures to aid the banking sector, including
recapitalizations, asset relief interventions, and liquidity measures other than guarantees. For
example, all the different forms of state aid approved by European Union member countries from
the first quarter of 2008 to the third quarter of 2012 add up to about 5 trillion euros, or about 40
percent of 2011 EU GDP.
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Third, balance sheet holdings of sovereign securities by the banking sector can represent
a substantial fraction of total bank assets in many economies, and can largely magnify bailout
costs for the government by reinforcing adverse asset price dynamics during banking crises. A
bailout of the banking sector lowers government debt prices, and the further deterioration of the
balance sheets of those banks holding public debt can induce a broader, more costly, public
bailout or even a sovereign debt default (Bolton and J eanne, 2011).
A second set of channels that help explain how banking crises can affect sovereign debt
sustainability relates to the macroeconomic conditions in the crisis country: first, as discussed in
Kaminsky and Reinhart (1999), banking crises commonly precede currency crises. As a result, a
large sovereign or banking sector exposure to foreign currency liabilities weakens the ability of
the government to act as a safety net for the banking sector, and increases the likelihood that
banking problems lead to a sovereign debt crisis.
Second, banking crises tend to induce severe economic downturns that weaken the fiscal
position of the government. A crisis in the banking sector translates into credit rationing and
higher borrowing costs for firms. For instance, non-financial firms may have to switch their
source of funding and tap bond markets, an option that may not be available to medium and
smaller firms especially during a crisis. Similarly, companies will likely have to rely more
heavily on more expensive working capital financing from other non-financial firms. The
collapse in tax revenues and the increase in public expenses from automatic stabilizers are
generally accompanied by a surge in public debt, sovereign credit rating downgrades and, on
occasions, sovereign debt defaults. Laeven and Valencia (2012) and Gennaioli, Martin and
Rossi (2013a) show and explain that the output losses and the increases in public debt tend to be
larger in advanced economies in part because deeper financial systems lead to more disruptive
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banking crises. Interestingly, fiscal costs relative to GDP, or to the financial system assets, are
larger in developing economies, but while the fiscal outlays in developing countries are largely
associated to bailouts, in advanced economies they represent a small fraction of the increase in
public debt, with discretionary fiscal policy and automatic fiscal stabilizers constituting the
largest component.

3. Transmission from sovereign stress to banks
The previous section discussed the effect of banking crises on the sovereigns solvency.
Sovereign stress can also have significant effects on banks solvency and their access to funding.
This section outlines some channels through which sovereign troubles can affect banks.

3.1 Sovereign debt holdings and bank solvency
The most direct channel for the transmission of sovereign stress to the banking sector is
through the banks holdings of sovereign debt. Banks maintain a portion of their assets in
sovereign debt for different reasons. In several countries, sovereign securities are the most liquid
asset available, and banks can use them to store their liquid reserves to satisfy deposit
redemptions (Gennaioli, Martin, and Rossi, 2013a). Banks also hold sovereign debt for
investment purposes. Traditionally, bank regulators have considered sovereign debt less risky
than corporate debt, allowing banks to fund a lower proportion of their sovereign debt holdings
with capital (Hannoun, 2011).
1
As we discuss later, banks also use sovereign debt for secured

1
Prior to the introduction of the Basel III capital requirements, supervisors followed the guidelines on risk weights
for sovereign exposures proposed under the Basel II capital accord (BCBS, 2006). Under these guidelines, debt
securities issued by a AA- rating or above would receive a 0 risk weight, while securities rated between A- and A+
would receive a 20 percent risk weight. However, the guidelines also stated that at national discretion, a lower risk
weight may be applied to banks exposures to their sovereign (or central bank) of incorporation denominated in
domestic currency and funded in that currency. Some countries relied on this statement to deviate from the
proposed guideline and assign different risk weights to sovereign exposures. For example, European Union
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funding transaction like repurchase agreements. Similarly, government debt may also be
pledged as collateral in derivatives transactions. Some banks also maintain sovereign bonds in
their balance sheet as part of their market-making role in the sovereign debt market.
Exposures to sovereign debt can lead to losses for the banks if the domestic or foreign
government that issued the debt becomes distressed. This type of bank loss has been common in
sovereign debt crises in both emerging and advanced economies. The most recent example is the
crisis that affected several euro-area countries starting in 2010. Before and during the crisis,
banks amassed large holdings of sovereign debt, some of it issued by countries with weak
fundamentals and large sovereign debt outstanding (Bolton and J eanne, 2011; Acharya and
Steffen, 2013). As the crisis deepened, countries like Greece restructured their sovereign debt,
triggering material losses on those banks with these types of claims on their balance sheets.
In episodes of sovereign default, the solvency of the banking sector is greatly affected
due to its sovereign holdings. However, the empirical evidence on the effect that sovereign
holdings have on banks during periods of sovereign stress, excluding defaults or restructurings,
is mixed. Some studies find that there is a significant correlation between sovereign holdings
and banks stock prices and CDS premiums in periods of heightened sovereign stress (Angeloni
and Wolff, 2012), while others find that the effect of sovereign holdings on stock returns is
weaker when focusing on sovereign rating events. Using a sample of banks that participated in
the 2011 EU-wide stress test, Correa et al. (2013) test whether the stock returns of banks with
more own-sovereign debt holdings had a significant reaction after the rating of their own-
sovereign debt changed, or was placed on watch for a future change. For this sample of banks,
the authors do not find that the stock returns of banks with larger sovereign exposures react

regulators transposed this requirement into European regulation in the Capital Requirements Directive (CRD),
which assigned a 0 percent risk weight on sovereign debt issued by a member state and denominated and funded in
domestic currency (Directive 2006/48/EC of the European Parliament and of the Council).
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significantly to negative rating changes in a window of one day prior and after the ratings
announcement.
These mixed results are not surprising, as sovereign debt can be used in most
circumstances, as collateral in transactions with domestic central banks (Bank for International
Settlements, 2013), the lender of last resort. Thus, in periods of broad liquidity stress, banks can
substitute private market funds for central bank financing using their sovereign debt holdings as
collateral, and remain viable institutions (Drechsler et al. 2013). However, as noted in the next
section, stress at the sovereign level may affect bank financing through some additional
channels.

3.2 Cost and availability of funding
The link between banks and sovereigns is not limited to the potential losses that banks
may face in the event of a sovereigns default. Banks funding costs may increase even in cases
when sovereign debt holdings do not lead to losses in their balance sheets. There are at least
three channels through which sovereign stress can affect banks funding costs: the collateral
channel, the ratings channel, and the government support channel.
The collateral channel describes changes in banks funding conditions that are explained
by the quality of collateral held by banks. An important portion of banks financing is done
through secured transactions, such as repurchase agreements, or repos for short (CGFS, 2011).
And one of the main securities used for these collateralized transactions is sovereign debt
(International Capital Markets Association, 2013). In a repo transaction, the amount of funds a
bank can borrow against a portfolio of securities will depend on the credit and liquidity risk of
that collateral. The buyer of these securities may impose a haircut (the difference between the
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market value and the purchase price of the asset at the start of the repo) to this collateral to take
into account such risks. In normal times, sovereign securities are considered to have very low
risk, thus, the haircuts applied to these securities are relatively small. However, in periods of
sovereign stress, banks that are reliant on sovereign collateral to conduct their secured financing
transactions may face notable funding constraints. The deterioration in the value of sovereign
collateral is more likely to affect banks domiciled in countries where the sovereign is in distress,
but it could also impact banks with holdings of sovereign debt issued by a foreign government in
distress, transmitting the funding shock across borders.
The second channel explains the changes in the cost and access to bank funding that are
triggered by the decision of rating agencies to downgrade (or upgrade) the debt issued by the
banks home sovereign. Rating agencies typically revise the ratings assigned to corporate issuers
after a review of the home-sovereigns own rating (Borensztein, Cowan, and Valenzuela, 2007;
Moodys Investors Service, 2012). Some rating agencies assign countries a ratings ceiling
(country ceiling) which determines the maximum rating that they can assign to a banks
foreign currency denominated liabilities (Fitch Ratings, 2008). This ceiling is closely linked to
the sovereigns own foreign currency debt rating and takes into account the risk of exchange
controls being introduced or the risk of other interventions by the sovereign that may impair the
functioning of the private sector.
As noted by the CGFS (2011), sovereign rating changes are closely followed by bank
ratings changes. In turn, bank rating changes have been shown to have an effect on equity
prices, affecting banks funding costs (Gropp and Richards, 2001). The effect of sovereign
rating changes on banks may also arise from movements in sovereign yields that later affect
aggregate bank borrowing costs (Gande and Parsley, 2005; Kaminsky and Schmukler, 2002).
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Black et al. (2013) show that a euro-area sovereign risk premium (the spread between Italian and
Spanish sovereign debt yields and comparable German sovereign yields) explains a significant
share of the increase in European banks contribution to systemic risk during the recent euro-area
sovereign crisis. This is evidence that a sovereign risk premium is priced into banks funding
costs. It is empirically difficult to disentangle the changes in bank funding costs that are directly
explained by sovereign ratings from those explained by actual changes in sovereign yields, but it
is clear that sovereign rating events have an important effect on bank funding costs.
This leads to the last transmission channel between sovereign risk and bank funding cost:
the government support channel. Several studies have identified a pattern of financing cost
advantages for institutions that are deemed to be supported by their domestic sovereign (the so-
called too-big-to-fail subsidy).
2
This implicit government support allows protected banks to
raise funds in capital markets at lower rates than comparable financial institutions not benefitting
from this implicit guarantee (Acharya, Anginer, and Warburton, 2013; Schich and Lindh, 2012).
Moreover, implicit government support typically translates into explicit support during a banking
crisis (Brandao-Marques, Correa, Sapriza, 2013). Both implicit and explicit support of the
banking sector depend on three factors: the willingness of the government to support the banks,
its ability or fiscal capacity to provide this support, and the size of banks and the banking sector
(Demirg-Kunt and Huizinga, 2013). Both the willingness and the structure of the banking
sector are factors that remain fixed in the short to medium term. Thus, the link between
government support and bank financing in the short run is mostly influenced by changes in the
ability of the government to provide support to the banks.

2
The concept that some banks are too-big-to-fail has been discussed in the academic literature since the 1980s.
Morgan and Stiroh (2005) and Flannery (2010) summarize several of the studies that have tried to assess the impact
of implicit government guarantees on banks.
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Figure 2 shows a measure of government support extracted from bank ratings assigned by
Moodys Investor Services, one of the three largest global rating agencies. The ratings uplift
captures the willingness and ability of a government to provide systemic support to a bank. It is
calculated as the difference, in ratings notches, between a banks foreign (domestic) currency
deposits rating and the bank financial strength rating (BFSR). We follow Brandao-Marques,
Correa, and Sapriza (2013) and calculate the ratings uplift for a sample of roughly 300 banks
in 54 countries between 1996 and 2013. This sample excludes subsidiaries of global banks, as
most of the ratings uplift for these institutions is accounted by the support provided by their
parent organizations. In addition, we calculate banks probability of receiving support from the
government based on the same ratings information. The probability of support is defined as
p=1-td/d, where d is the default frequency implied by the BFSR of a bank and td the default
frequency based on the deposit rating. We map the BFSR rating of a bank and its deposit rating
to the historical one-year-ahead default frequencies collected by Moodys Investor Service
(2011) to calculate the probability of support.
In figure 2, we show the median ratings uplift as well as the implicit probability of
government support for this sample of banks. These measures clearly show an increase in
expected government support tied to systemic banking crises like the Asian and J apanese crises
in the late 1990s and the more recent financial crisis in the late 2000s. Although not captured in
the graph, the recent sovereign European crisis, which strained several countries in peripheral
Europe, led to a reduction in rating agencies expectations of government support for banks in
the most deeply affected countries (e.g., Greece and Ireland). The reduction in expected support
did not arise as a result of the governments unwillingness to provide support to the banks, but it
is largely explained by the lack of fiscal capacity to provide such support.
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[Insert Figure 2]
Events in which the sovereigns creditworthiness is in doubt will reduce the markets
expectation that the government would be able to support the banks and increase banks funding
costs. This link is not limited to the cost of bank-issued debt, as it affects all components of the
capital structure including the cost of equity (Correa et al., 2013). The impact also varies across
banks within a country. Financial institutions that are perceived to enjoy more government
support will experience larger increases in funding costs. These institutions are typically large
banks or banks that are partially or fully owned by the government. As their funding costs
increase, banks will adjust their balance sheets to cope with the increased financing costs.
It is difficult to empirically identify the contribution of each of these channels to banks
funding conditions during periods of sovereign stress. However, the European Central Bank
(ECB), as part of its euro area bank lending survey, has collected information on the banks
views on the impact of the euro-area sovereign debt crisis on their funding conditions since the
first quarter of 2012.
3
There are three factors that may affect banks funding conditions for
which the banks are asked to provide an opinion and that are related to the channels described
above, namely: the direct exposure of banks to the sovereign; the value of sovereign collateral
available for wholesale funding transactions; and other factors, which include automatic ratings
downgrades affecting your bank following a sovereign downgrade or changes in the value of the
domestic governments implicit guarantee. Although this information is available for a short
period of time and geographical location, it can provide some insights into the interplay between
sovereign risks and bank funding.

3
Results of the euro area bank lending survey can be found at this location:
http://www.ecb.europa.eu/stats/money/surveys/lend/html/index.en.html
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Figure 3 presents the euro-area banks responses to the questions related to the link
between sovereign risk and bank funding. The lines in the figure show the difference, in
percentage points, between the shares of banks reporting that a factor contributed to a
deterioration of the banks funding conditions and those that reported that it contributed to an
easing of funding conditions. The answers are weighted based on the share loans outstanding of
each country in total euro-area lending. As shown in the figure, the three factors were significant
contributors to banks funding conditions in early 2012, a period of heightened sovereign stress
in the euro area. After that episode, the importance of these factors has decreased substantially,
with the exception of mid-2012, when Greece restructured its debt. One important pattern to
note is that the other effects, which are related to bank ratings changes linked to sovereign
rating events or changes in a governments implicit guarantee of banks, have remained a drag on
banks funding conditions, underlining that these factors are materially important.

[Insert Figure 3]
The close relationship between sovereigns and banks increases the fragility of the system,
as it amplifies shocks that either one of these sectors may suffer independently. As a result,
broad domestic economic conditions may suffer and spillovers may affect other countries. The
effect of the sovereign-bank negative feedback loop on real outcomes will be explored in the
next section.

4. Sovereign stress and its effect on banking activity
Sovereign debt crises have significant effects on economic activity (Furceri and
Zdzienicka, 2011). The impact is larger when sovereign stress is accompanied by problems in
19

the banking sector (DePaoli et al., 2009). However, there are very few studies that document the
direct contribution of the banking sector in these types of episodes. This is understandable, as
crises are broad events in which it becomes difficult to identify the impact of individual
contributors. The recent euro-area sovereign debt crisis, with its prolonged duration and
heterogeneous effects across countries, has proven to be fertile grounds for analyzing the
behavior of banks in periods of sovereign stress. We rely on a set of new studies focusing on this
period to analyze the real economic impact of sovereign and banking crises.

4.1 Lending
Banks close relationship to its domestic sovereign may affect its lending activity during
periods of sovereign stress. As noted before, there are several channels through which
deteriorating conditions for the sovereign may affect banks level of capitalization and their
access to external financing. In turn, these shocks to banks balance sheets also affect their
lending activity. However, it is very difficult to empirically isolate the direct and causal effect of
sovereign stress on banks supply of credit. Sovereign crises are typically accompanied by
recession that may affect borrowers demand for credit, and these crises may be triggered
themselves, by problems in the banking sector. These confounding effects make it difficult to
identify the amplification mechanism provided by banks during a sovereign event.
Despite these identification problems, some studies have attempted to test the impact of
sovereign distress on bank lending. Focusing on a cross-country sample of sovereign default
episodes, Gennaioli, Martin, and Rossi (2013a) find that aggregate private credit falls more in
those countries where the banking system is more exposed to sovereign debt securities. These
results are consistent with their theoretical model, in which banks optimally hold public bonds as
20

an instrument to store liquidity. As the government defaults, domestic banks liquidity decreases
and this affects their ability to lend. In their empirical analysis, their identification strategy
focuses on the cross-section. The authors collect information on 110 defaults for 81 countries
between 1980 and 2005. The main estimation of the paper tests whether banking sectors with
larger net claims on the government reduce their private credit to GDP more severely during
sovereign default episodes. The results are economically significant, as a one standard deviation
increase in a banking sectors exposure to a defaulting sovereign implies a larger reduction in
private credit to GDP of about 2.5 percent.
These results are also significant at the bank level. In a subsequent paper, Gennaioli,
Martin, and Rossi (2013b) use a sample of roughly 4000 banks in 140 countries to analyze the
effect of individual banks exposures to government debt on lending during 12 sovereign
defaults between 1998 and 2012. The authors find that banks with larger exposures to
government debt, in an episode when their own-sovereign defaults, decrease lending by more
relative to their total assets. This result is mostly explained by banks permanent holding of
government debt, as opposed to transitory increases in government debt holdings during these
crisis episodes.
As shown by these studies, sovereign debt crises have a significant effect on domestic
credit. This negative shock is compounded by the marked effect that sovereign crises also have
on firms access to foreign sources of credit. Arteta and Hale (2008) find that countries enduring
a debt crisis have limited access to international debt markets. The impact is stronger for non-
financial private firms that do not export their goods and services.
As a whole, these results provide some direct evidence on the effect of sovereign defaults
on domestic and cross-border bank lending, which could translate into aggregate macroeconomic
21

outcomes. However, there is still some room for causality going in the opposite direction, as the
macroeconomic conditions that led to the default or debt crisis are perhaps correlated with the
characteristics of borrowers from banks that are more exposed to the sovereigns in distress.
The European sovereign debt crisis of the early 2010s has provided some empirical
evidence to support the hypothesis that banks amplify the impact of sovereign distress on the
economy through their lending behavior. Using micro-level data for Italy, Bofondi, Carpinelli,
and Sette (2013) find that Italian banks lending grew by less than the credit provided by foreign
banks in Italy during the recent sovereign episode. In addition, the authors show that the interest
rate charged by these domestic banks also increased as conditions deteriorated. These results
demonstrate that, even without default, the banking sector can amplify sovereign stress by
adjusting their lending.
Sovereign financial stress can also be transmitted to other countries through global banks.
As banks with large international operations face capital shortfalls due to losses on domestic (or
foreign) sovereign exposures, they may pair down their participation in cross-border lending
arrangements in the form of syndicated loans. Popov and Van Horen (2013) show that European
banks with notable exposures to sovereign securities during the recent European debt crisis
increased their global syndicated lending at a significantly lower pace than counterparts with
smaller exposures to these countries.
Liquidity pressures are another source for the transmission of sovereign risk. Global
banks with foreign operations (e.g., branches), particularly funded with wholesale financing, may
lose access to local funding as their domestic sovereign becomes stressed. The ensuing liquidity
shock forces the global bank to replace that local funding with financing sourced at the parent. If
the new inflow from the parent is not enough to finance new or existing lending, the foreign
22

office of the bank will have to adjust its lending. Correa, Sapriza, and Zlate (2013) show that
this mechanism was also important during the European sovereign debt crisis. U.S. branches of
European banks faced rapid withdrawals from U.S. wholesale investors, mostly U.S. money
market funds, triggered by broad fears about the European sovereign crisis. The branches
parents replaced some of the outflows with their own funds, but these resources were not enough
to compensate for the reduction in financing from non-related sources. As a result, branches had
to decrease their lending, which is mostly done through syndicated arrangements. Firms with
links to the affected branches endured real adjustment, as they invested less compared to similar
firms that had lending relationships with unaffected branches.
Transmission of sovereign shocks can also take place indirectly through interbank
lending. As shown in Schnabl (2012), a sovereign in stress may lead global banks with
exposures to that country to pull back on their lending to banks in other countries. In turn, the
domestic banks affected by limited access to international debt markets will cut on their lending
and their borrowers will reduce their economic activity. This type of contagion risk grew rapidly
prior to the financial crisis of the late 2000s, as global banks became more interconnected and
increased their involvement in international capital markets.
In sum, sovereign distress can be amplified through the banking sector contributing to the
poor macroeconomic outcomes observed after debt crises episodes. Moreover, sovereign debt
problems can also by transmitted to third countries through global banks that are directly or
indirectly exposed to the sovereign in distress. But lending is not the only activity that banks
adjust during debt crises. That will be the subject of the next section.

4.2 Sovereign stress and risk taking
23

As we outlined before, banks adjust their lending activities during periods of sovereign
distress. However, sovereign debt crises may also alter other activities conducted by financial
institutions. In some cases, the outcome of this adjustment may lead to a higher level of risk in
the system with additional macroeconomic implications.
Bank assets are traditionally composed of loans and securities. These securities are
further decomposed between those issued by the private sectors and those issued by the
sovereign or local governments. In periods of sovereign stress, banks may have an incentive to
shift the composition of their securities holdings. As noted before, under normal circumstances
banks will hold sovereign securities as a means to maintain liquidity and repay withdrawals from
depositors or other creditors (Gennaioli, Martin, and Rossi, 2013a,b). In contrast, in periods of
sovereign stress, banks may find it desirable to increase their holdings of risky sovereign
securities to increase their returns (Acharya and Steffen, 2013). This risk-taking behavior may
enhance the adjustment that banks will have to perform in the event of a sovereign default.
There are several factors that explain the banks decision to increase their sovereign debt
holdings in periods of stress. First, sovereign securities are perhaps the safest asset for domestic
banks, as private sector borrowers may become riskier under weak macroeconomic conditions.
However, as shown by Acharya and Steffen (2013), banks without this constraint may also
increase their holdings of risky sovereign securities. This was the case for some European
banks, which purchased debt from foreign sovereigns in distress during the recent European
sovereign crisis.
Second, banks may have the incentive to arbitrage regulatory rules. As noted before,
risk-weights on sovereign debt securities are zero in most cases. If the bank is faced with the
option of making a loan or holding a sovereign security, regulatory requirements may tip the
24

balance toward the latter. Consistent with this claim, banks with lower regulatory capital levels
were also found to increase their risky sovereign holdings in the European sovereign crisis.
Third, securities issued by sovereigns are one of the main types of collateral used by
central banks in their liquidity operations with banks. As such, banks will have an incentive to
hold more of these securities to be able to access the funding provided by the lender of last resort
during a crisis. However, banks could take advantage of this arrangement by purchasing and
pledging increasingly riskier sovereign debt as collateral in central bank operations. Using
micro-level data for euro-area banks, Drechsler et al. (2013) find that both mechanisms are at
play in periods of financial and sovereign stress. Banks hold more sovereign debt to be able to
access liquidity from the lender of last resort, but they also shift some of their holdings to
riskier sovereign securities.
Banks lending activity is not the only dimension that banks can adjust in periods of
sovereign stress. They can also adjust their risk-taking by arbitraging regulatory rules and the
role of the lender of last resort. The main consequence of this action is an increase in systemic
risk which could deepen a sovereign crisis. The question that arises from these findings is
whether policy makers can adjust the system to take into account the negative structural feature
embedded in the relationship between sovereigns and banks. That will be the subject of the next
section.

5. Breaking the sovereign-bank feedback loop
The close connection between banks and sovereigns leads to financial instability by
amplifying any shocks that affect either sector. A countrys fiscal position typically becomes
strained as it intervenes to support the banking sector during periods of financial turmoil. This in
25

turn leads to worsening conditions for the banks due to an increase in their cost of financing and
a deterioration of their balance sheets. This feedback loop between the sovereign and the
banks exacerbates any shock that in isolation would have resulted in smaller macroeconomic
effects.
Sovereign distress can be the product of a broad spectrum of problems, both structural
and cyclical. The factors that impact a governments finances span from demographic changes
to fluctuations in commodity prices that affect the exporting sector in a small open economy.
The focus of our analysis will be on just one of those factors, the impact of the financial safety
net on the sovereign feedback loop. The safety net is defined as the system of explicit and
implicit guarantees provided by the government to protect a countrys financial infrastructure
from systemic events (Kane, 2004). The most common component of this safety net is the
deposit insurance scheme, which is intended to provide a guarantee to depositors in case of a
banks insolvency. Other guarantees are implicit or implemented during periods of systemic
stress. In the event of broad bank insolvencies, these guarantees are likely to become explicit,
and lead to a deterioration in the fiscal position of the sovereign (Laeven and Valencia, 2012).
Given the features of the current financial safety net and its impact on the sovereign, the
following question arises: how can a country minimize the macroeconomic impact of a banking
crisis, while reducing the fiscal cost to the sovereign?
It is unrealistic to assume that banking crises can be resolved without any
macroeconomic effects. However, some aspect of the safety net, if not well designed, may
exacerbate these crises through its impact on the sovereign. There are at least three adjustments
to the safety net that can be implemented to minimize the effect of the sovereign-bank
feedback loop: a well-established and transparent bank resolution regime, a deposit insurance
26

scheme that is optimally priced, and capital requirements that reduce the probability of failure of
a bank.
The European Union has adopted some of these measures to deal with the sovereign
stresses affecting some countries of the euro area since 2010. A proposed EU banking union
would include a single supervisor, a well-defined resolution regime, and a consistent structure of
deposit insurance schemes across the region. Although progress has been made (Beck, 2013),
and this in turn has reduced banks funding pressures, there are still several adjustments to the
safety net that would have to be implemented to break the sovereign-feedback loop.
The first desirable adjustment to the safety net is to implement a bank resolution
regime that minimizes the cost to taxpayers from banking failures, especially of large banks.
Some countries have already moved in this direction by establishing rules that would make it
easier to resolve such large financial institutions (FDIC and BoE, 2012). A well-defined
resolution regime, which would likely include provisions for the bail-in of subordinated, and in
some cases, senior creditors, also has the additional benefit of enhancing market discipline. As
governments rely more on this tool to resolve banking crises, rather than bailing out banks
through capital injections or other means, investors will price the debt of banks taking into
account the credit risk posed by each institution, reducing the so called too-big-to-fail subsidy
(Acharya, Anginer, and Warburton, 2013).
Deposits insurance schemes are a common feature of the safety net. However, a poorly
designed scheme may lead to financial instability and significant costs to the sovereign in the
event of large or multiple bank failures. Banks operating in an environment with this type of
guarantee are prone to increase the riskiness of their assets due to moral hazard, which in turn
may increase the likelihood of a banking crisis (Demirg-Kunt and Detragiache, 2002). To
27

limit the cost to the sovereign in the event of a crisis, the deposit insurance scheme should be
explicit and it should clearly define the financial institutions and depositors covered (Financial
Stability Board, 2012). In addition, to limit banks risk-taking incentives, the pricing of deposit
insurance premiums should be sensitive to each financial institutions own risk, as well as its
contribution to systemic risk (Acharya, Santos, Yorulmazer, 2010). These conditions are
necessary, yet not sufficient, to reduce the effect of deposit losses on the sovereigns finances.
Lastly, increasing the resilience of banks to shocks is probably the best alternative to
insulate the sovereigns from problems arising in the financial sector. A tool available to bank
regulators is the imposition of capital requirements for banks. The establishment of high capital
requirements can be thought of as a mechanism to internalize the externality posed by the
systemic consequences of large bank failures. Increasing the reliance on capital to finance bank
assets may be costly (J imnez et al, 2013), but these costs are outweighed by the social benefits
of fewer bank failures and better bank performance during banking crises (Berger and Bouwman,
2013). Additionally, capital regulation should incentivize banks to accurately reflect the risk
embedded in sovereign debt. Allowing risk-weights to be sensitive to sovereign creditworthiness
may prevent banks from holding large and concentrated exposures to government-issued debt.
In general, a banking sector with more capital financing will decrease the cost to taxpayers of
resolving banks that are still deemed systemically important.
28

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34



Figure 1. Links between the sovereign, banks, and the real sector.

35


Figure 2. The ratings uplift and probability of support are measures of
expected government support of banks calculated based on Moodys Investors
Service ratings information.

0
.
1
.
2
.
3
.
4
P
r
o
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a
b
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i
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n
o
t
c
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e
s
1996 1998 2000 2002 2004 2006 2008 2010 2012 2014
Year
Ratings uplift (median) Probability of support (median)
36


Figure 3. The figure shows the difference, in percentage points, between the
shares of banks reporting that a factor contributed to a deterioration of the banks
funding conditions and those that reported that it contributed to an easing of
funding conditions. The answers are weighted based on the share loans
outstanding of each country in total euro-area lending.
-
1
0
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1
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2
0
3
0
4
0
N
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t

p
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2012q1 2012q3 2013q1 2013q3 2014q1
Quarter
Direct exposure to sovereign Other effects (ratings, gov. support, etc.)
Value of sovereign collateral